Looking for your help (skin in the game)

I’m looking for some help from anyone with knowledge of life in the investment bank world. Please read on.

Peter Weinberg writes in the WSJ[2] that the problem with Wall Street is that they didn’t have enough skin in the game. He explains how it used to be when investment banks were partnerships:

The only private partnership I can talk about authoritatively is the one in which I was a partner from 1992 to 1999, when the firm went public: Goldman Sachs. Partners there owned the equity of the firm. When elected a partner, you were required to make a cash investment into the firm that was large enough to be material to your net worth. Each partner had a percentage ownership of the earnings every year, but the earnings would remain in the firm. A partner’s annual cash compensation amounted only to a small salary and a modest cash return on his or her capital account. A partner was not allowed to withdraw any capital from the firm until retirement, at which time typically 75%-80% of one’s net worth was still in the firm. Even then, a retired (“limited”) partner could only withdraw his or her capital over a three-year period. Finally, and perhaps most importantly, all partners had personal liability for the exposure of the firm, right down to their homes and cars.

So why did that change? Why did these partnerships go public? My understanding is that by going public they could get a lot bigger. The injection of outside equity means that they can borrow a lot more money for any given level of leverage.

But that raises what I consdier the central question of the crisis. Why would lenders lend large sums of money financing investments made by people who now have less skin in the game? Before, when it was a private partnership borrowing money, the partners were investing their own money. Now they’re investing other people’s money–the equity holders and the larger absolute amount of money coming from the loans. Why would lenders play that game, knowing that the investors have an incentive to take more risk.

If the lenders do play this game, they should expect larger and larger amounts of leverage financing riskier and riskier loans. Why would they keep financing investments they have no upside stake in while their downside risk gets larger? Why would they keep doing this as Wall St. execs paid themselves larger and larger bonuses, further reducing their personal downside risk from their investments?

The obvious answer is that they presumed that if push came to shove, they would get bailed out. Their downside risk was actually much smaller than it appeared to be. And they were lending to each other, increasing their connectedness and the chance of a bailout if the worst-case scenario came to be. And that is precisely what happened in every case other than Lehman. Essentially, the whole thing was a Ponzi scheme played with your money and mine, taxpayer money.

Is there an alternative view? One thought I have is that one way such a strange highly leveraged world could emerge without an implicit government subsidy is by shortening the period of the loan. Was the overnight repo market a way that Wall Street was able to get more leveraged even in the absence of an implicit subsidy? Certainly this was a way of hedging their bets about the likelihood of a bailout or rescue.

Feel free to comment below on these ideas. But I wouldn’t mind hearing privately russroberts at gmail.com (or publicly in the comments) from anyone who has any personal experience of this world or data about what else changed when Wall Street stopped being a group of partners and went public. Am I right that Wall Street got a lot more leveraged? Did the funders of that leverage change?